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April 14, 2008

4 Min read

There has been quite a lot of discussion on this investment idea. You can check the comments for that.

A few key points in the valuation of the company are as follows. I have uploaded the valuation (valuationtemplatev3NIITtemp.xls) based on the factors below in google groups. Please note that this is a rough back of the envelope calculation (see net impacts section of the spreadsheet) and may be off by 10-20%.

Impact of ESOP – This can be computed and I have detailed my logic in the comments. It is not completely accurate. However considering that ESOP’s account for 6-8% of the company’s current Mcap, a 20% errror would not amount to more 2-3% error in the computation of the intrinsic value. That is an acceptable error for me (although you would flunk a derivatives class for that error) as It would not change my overall conclusions.

Tax impact – I do not have the exact numbers on what the changes are. However for NIIT the current tax rate is around 15%. The average tax rate for Corporate india is around 25%. I have assumed that NIIT would be paying the average rates from 2010 onwards. You can see the impact of the tax changes in valuation excel I have uploaded in google groups.

US slow down and dollar depreciation – cannot really compute the impact. The downside is limited due to the fact that NIIT tech has 30% revenue from US. However that does not mean than Europe and Rest of world are immune from a US recession. I have taken the impact of a slowdown and dollar depreciation by considering that the net margins will drop from 14.5% to around 7.5% in the next two years. It could drop below that too …although the probability is low (my guess is good as anyone else). As a result of this the net profit could drop from around 130 Crs in 2007 to 90 Crs in 2010.

Forex hedge – The company does not have large hedges. So I do not see any open risks from hedges (such as the one which hit hexaware). However one cannot rule out such a risk in the future

ESOP computations – See section ‘options’ in the uploaded excel

Basic logic is as follows (which differs from the text book approach). This approach may have flaws and I think it is overly conservative.

i do not consider just the granted options alone. I consider all options already granted and to be granted. As the options approved by the board will be granted in the future and that would then dilute the shareholder’s equity in the business
a) Adjusted mcap = current price * (all options+issued stock).

Options which lapse can be re-issued to new employees, so lapsed options should not be netted out.b) value lost due to free options to employees – The option price is given in balance sheet (ESOP are not free to shareholders)
so reduction from intrinsic value = total options to be issued or exercised* option pricenet intrisic value = DCF based intrinsic value – cost of optionsso based on above i now compare adj mcap with net instrinsic value. If the adj mcap is 50% or below Net intrinsic value, then it is a buy for me.

Finally a correction – As pointed by others in the comments, I have calculated the net cash incorrectly. Post accquisitions and net of debt the net cash could be around 200-250 Crs (what are a few crores here or there 🙂 ?). Luckily that does not change the final conclusions much for me.

Please feel free to leave a comment for me if you find errors in my valuation.

Please read disclaimer at the bottom of the page. In addition I have a position in the stock.

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Analysis – NIIT Tech

By Rohit Chauhan

In Investment ideas, Uncategorized

April 9, 2008

4 Min read

31 comments

Note: The analysis below is dated end of march – beginning of april. The stock has had a major jump since I started analysing the company. In interest of disclosure, I have a position in the stock. So please take this as a biased analysis. In addition I do not know if the jump in price is temporary and the price will fall again or it will continue rising. So as usual, please do your own analysis, read my disclaimer below and don’t blame me if your decision is based on my analysis alone. In summary – I am not recommending anyone to buy or sell the stock.

About
NIIT technologies is a 900 Crs company. It is a spinoff from NIIT ltd and is in the business of ITES and BPO. The company has 50% of revenue from Europe, around 30% from US and the rest from Asia, and other parts of the world

The company has a focus on a few key verticals such as BFSI (more in insurance), Transportation and retail services. The company has done a few targeted accquisition (such as ROOM solutions) in the above verticals in the last few years. In addition the company has signed a few JV’s too in the past. The company thus seems to be following an organic and in-organic path to growth

Financials
The company has done well in the past few years with ROE increasing from 17% to 30%+ in 2006. This has been driven by improvement in margins from 6% to around 12-14% in the recent years.
The revenue has also grown from around 500 Crs in 2004 to around 1000 odd crores in 2008 (expected). This translates into a revenue growth of around 18% p.a. The Net profit has grown from 33 Crs to around 110 Crs in 2007.

Positives
The company has a cash balance of almost 250 Crs (2007) which could rise to 350 odd crs (approximate). This would account for more than 60% of the market cap of the company.The company has almost 50% revenue from europe and thus is less exposed to the dollar risk and recession in the US.
In addition the company seems to be growing well, improving margins and increasing scale. At the same time the revenue from top 10 clients as a % of total revenue seems to be coming down, which is a good thing.
The company has a repeat business of almost 89% which shows good stability of revenue.

Risks
The obvious ones – US dollar, global slowdown etc etc.
The non obvious – The company is mid-tier ITES company. It still does not have the scale of the tier I vendor. However if the company focusses on the specific verticals and scales up in those verticals, then this disadvantage could be eliminated
In addition the company is pursuing accquisitions also. This is always a riskier way to grow.

Competitive analysis
The ITES business depends on the following key factors
a) scale : NIIT seems to be building scale in specific verticals. This would be the key to the company’s future
b) Customer lock in: This seems to be working for the company as the repeat business is fairly high

The other factors such cost advantage, overall scale etc is no longer a key differentiator as all ITES companies have this advantage and it is now considered as a minimum requirement in this business.

Valuation
The company sells at 1-2 times Net profit (Net profit is equal to free cash flow here) if you take out cash. The market is pricing NIIT tech with a view that the company will be out of business by 2010.

Conclusion
Short the company shutting down by 2010, it cannot think of any other justification for such valuations.
Dollar depreciation, US slowdown and increase in taxation rate can hurt margins. However ITES companies have some flexibility and control on the net margins through variable pay, utilization etc. So even if the margins drop by 50% to around 6-7%, the company will still sell at 4-5 times PE which is still quite low.

In summary, the market is pricing NIIT tech to be out of business in the next 1-2 years. That is a very low probability event in my view

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Prof Greenwald’s valueinvesting talk

By Rohit Chauhan

In Uncategorized

April 5, 2008

3 Min read

Add comment

Prof Bakshi co-hosted a valueinvesting talk by Prof greenwald and has uploaded the presentation on his website here

I have read prof greenwald’s book on competitive analysis twice and have found his book very useful. You can see the usage of the concepts in my valuation templates too.

My notes on the presentation

– A lot of analysts consider only equity value in the valuation. Debt is also important
– On valuation basis a number of companies especially midcaps are priced at or below asset value. The market assumes these companies are worth more dead than as a going concern
– Most valuation approaches for PE are based on growth. As prof greenwald rightly points out, PE depends on multiple factors such as cost of capital, cyclical position, management etc too. Important to adopt multiple valuation approaches rather than a single simplistic approach based on PE alone.
– Looking back, my most successful investments were in companies selling below asset value, but having a moderate growth and a certain amount of competitive advantage. The returns were realised when the market revalued the company to reflect the true value (for ex : asian paints, blue star, concor, Guj gas, pidilite, ICICI bank etc)
– Great section on barriers to entry (see here for academic understanding of demand supply curves). I had an idea of the demand supply curves and other concepts of competitive advantage. This is the first time I have been able to get an understanding of how these two concepts interact – great learning.
– Slide 27-33 has great explaination of how competitive advantage concepts can be combined with basic micro-economic theory.
– Slide 36 should be an eyeopener if you expect as a lot of market participants do, that the market should give an average of 25% returns per annum or higher. Even with the drop and shrinkage in PE, the prospective returns look like 10-11%.
– Slide 40 – A number of indian companies such real estate, capital goods are showing high ROE, high growth and hence high valuations. Is the growth and ROE sustainable? The high valuation will be justified only if they are sustainable. With competitive pressures, difficult to see how all companies in a sector can maintain high returns and high growth rates.
– Not able to understand the slide 42 completely. But it is interesting to apply the calculations to companies which are selling at PE’s of 40 or higher. Clearly lot of expectations from such companies.

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Inflation, Rupee-dollar rate and impact on stocks

By Rohit Chauhan

In Uncategorized, Views on news

March 31, 2008

2 Min read

10 comments

I generally avoid a macro view on stocks. It is quite difficult (for me) to analyse a macro event and then come to a stock specific conclusion.

However there seems to be broad trend of dollar depreciation (that not news 🙂 ) due to variety of reasons – subprime, US current account deficit etc etc. A drop in the dollar does not always translate into a rise in the rupee as ours is a managed currency. However inflation and its impact on elections is a powerful motivation for the government to appreciate the currency (imports such as oil become cheaper).

Recently inflation hit 6%+ and it is quite likely that one of policy decision could be to allow the rupee to appreciate. Sudden or slow appreciation? I don’t know. However an appreciating rupee impacts my stock strategy as follows

– IT stocks could get hit further. I doesn’t matter that some are selling at 2-3 time PE and are being priced for bankruptcy. The market is not rational always. If IT stocks could sell for 100 times earnings, they could drop further.
– Oil companies could benefit ..the key word is could. For all you know, the government could drop the prices and pass the benefit of the rupee appreciation to the consumer.
– Export based industry such as textiles etc could be in for a tough time. Makes sense to find the strongest players and invest only in those companies which can pass some of the currency impact to the customers.

I am not changing my stock specific plan drastically. No moving out of export dependent companies and moving into import driven companies and all that. It is quite diffcult for me to figure out the exact impact of such macro factors in the long run.

I am not a contrarian by nature, but going against convential wisdom has been very profitable for me. So as it becomes an accepted wisdom that IT companies or other export driven companies and their stocks are doomed forever, I plan to look more closely at them (and buy if I find them attractive and oversold). and I will not blame you if you feel I am out of my mind to think of IT or export driven companies. I am now very used to that feedback 🙂

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Mr Simpleton and Mr Hotshot Investor

By Rohit Chauhan

In General thoughts, Uncategorized

March 26, 2008

3 Min read

11 comments

Simpleton and hotshot investor are close friends. Simpleton is a small time businessman …doesn’t understand stock market much. But he knows cash is king. Hotshot is all into investing. Reads blogs like this, talks of DCF, PE, options, subprime and all that.

So one day Hotshot comes to meet simpleton and both get talking of business and stocks and all that.

Hotshot – how’s business?

Simpleton – ok …not too good though. You know that store I have. Used to do very well, but now with that new mall, business is not so good. Too much competition

Hotshot (all puffed) – So why don’t you sell it and put the money in stock market ? You know I made 5 times my money in the market in the last 3 years!!

Now this gets simpleton thinking ..here I am working hard and barely making 20% return every year and this cool dude is able to make so much money.

Simpleton – you study all this stock and business…you analyse all these big companies. How much should I sell my business for ?

Hotshot (opening his sleek laptop) – You know, I have analysed so many companies. I have this complicated spreadsheet. Just give me the numbers and I will tell you

Simpleton – let me see. Last year, I had sales of around 5,00,000 per month and I made around 50,000 per month after all expenses. I keep around 7,00,000 of inventory and I give some credit also. So I have a debt of around 3,00,000 per month. As of now I am having around 7,00,000 cash also in safe. Store is my own, so I don’t have to pay rent.

Hotshot – those are last year’s numbers. How much did you make year before that and last 5 years. I need all those numbers for my spreadsheet.

Simpleton – Around the same. I told you ..too much competition. But you know, I have some loyal customers, so last 5 years I have been making roughly the same. Maybe 3-4 % increase every year.

Hotshot (shaking his head) – not good, not good. No growth ..bad ..very bad. Why don’t you invest this cash some in high growth business

Simpleton – You know, I have not done any other business and I have been managing this store for last 15 years. So I don’t think I will be good at it. Actually, 5 years back I opened a chicken farm and lost all the money …you know bird flu !! . So whatever profit I make, I keep it as cash.

Hotshot (shaking his head even more now, lets out a sigh) – then you have to sell your business for 7,00,000. At best 10,00,000. See no growth, means no future

Simpleton (completely surprised) – what are you saying ? I have cash of 7,00,000. I have inventory, this store and all this good will !!

Hotshot (shutting down his laptop) – All that doesn’t matter. No growth …means no growth. If you cannot grow ..your business is worthless !! don’t believe me .. I will show big companies selling for peanuts because they cannot grow. I am not saying that …the stock market which has millions of intelligent people are saying that !

Simpleton cannot believe what hotshot is saying. How can it be true ? why should he sell his business for the cash he has in the safe ? If he sold his inventory and the store, he would make more money. But then he thinks ..the stock market must be smarter than him !!

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Portfolio management and anchoring

By Rohit Chauhan

In Investment process, Uncategorized

March 20, 2008

3 Min read

4 comments

A lot of energy is wasted around discussing the market levels. Short of buying an index, I think if you are focussing on a company, the market levels do not matter. If the company is overvalued in your opinion, the market level will not matter and vice versa. So all the decision is around the stock price and its relationship with the intrinsic value.

That said, it is not easy to ignore the noise. In order to so do, I have modified the way I manage my portfolio and track individual stocks. I have done this also to avoid anchoring to the price at which I buy the stock. To read on anchoring see here

The normal tendency is to look at how the stock has done v/s the price at which it was bought. So I used to get pained if it went below the buy price and happy when it went above. That can mislead us – this is how

Suppose the company you bought came out with results which are poorer than expected. You analyse the results and realize your estimate of the intrinsic value is off by 30%. What should you do ? If you are anchored to the purchase price and if the current price is higher, you tend to discount this information and may continue to hold on to the stock, when a good decision could be to sell.

This is how I currently try to avoid the problem –

I maintain a spreadsheet of all my holding with the following columns

Name
No. of stocks
Intrinsic value estimate
Buy price
Current price
Discount to intrinsic value (intrinsic value- current price / current price)
% gain/ loss

I am constantly looking at the discount to intrinsic value number. If the price drops and the discount is more than 50%, I start buying. If the discount is less than 50%, I sit pat.

After every quarterly/ annual results, I review the instrinic value estimates again and update this number. Check the discount again and buy if below 50%. In addition if I come across some information which I had not considered, I review the instrinsic value again.So the comparison is always to the intrinsic value (which is changing based on new information) and buy/hold or sell decisions are based on the discount to the intrinsic value.

The above ensures that I am not fixated to the current price or market level or what the analysts are saying – Ok I am joking about analysts, I never bother about their opinions (prefer to make my own blunders).

Next post : Adding, selling stocks and adjusting wieghtages

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Ouch !!

By Rohit Chauhan

In General thoughts, Uncategorized

March 17, 2008

3 Min read

11 comments

Jan 9th – Mar 17th – Returns = -27% and counting.

There is quite a bit of panic and fear in the markets now. It is amazing what difference 3-4 months can make.

It is easy to get preachy, especially if you don’t have skin in the game. But I am not in that position. My own portfolio shot up like a rocket from september and has come down since then. I have seen worse bear markets in the past where the index just kept sliding down for 2-3 years. Will it happen again now? There are enough forecasters and gurus out there forecasting. I don’t want to add to that noise further.

This is what I am doing .

1. Don’t panic – seriously!!
2. Stop watching the market, your portfolio and CNBC – I am half serious about this. This will only induce more panic
3. Don’t anchor – If you were watching a stock for sometime and it has dropped by 20 – 30% from the peak price, it does not mean that it is cheap. There is no point anchoring on the past price. The stock is cheap only if the current price is at a discount to its intrinsic value. So I would not rush out and start buying blindly just because the market has dropped
4. If you have been analysing and watching stocks for some time, a few stocks maybe dropping below the buy targets. It may be time to start buying. Will the stocks go down further …that’s possible. But if you think the stock is undervalued, I would ignore these fluctuations.

The above suggestions are valid if you have followed a long term investing strategy (where long term is more 1 year) and have not been a trader/ momentum player. For traders/ momentum players I have no suggestion as that is a different game, which I have no clue about.

Beyond this I don’t think there is much to do. Ofcourse I am assuming there is no leverage involved and you can psychologically handle the losses.

As I have said earlier and this becomes more and more evident as time goes by – It is close to impossible to predict the market. So I think no one can say whether the market will go up and start dropping again or resume its rise again. What we can do is to be rational about our investment approach and keep a margin of safety

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Clusters of Investment ideas

By Rohit Chauhan

In Investment ideas, Uncategorized

March 14, 2008

2 Min read

5 comments

I am finding more ideas in some sector/ sub-sectors than others. Such as,
– IT midcaps
– MNC Pharma
– Auto components
– Auto OEM

For some reason, valid or otherwise, most of the companies in these sectors have been beaten down. The reason range from genuine concerns (US recession, Rupee appreciation etc for IT sector) to investor apathy (MNC Pharma). My approach in such cases is to list all the companies in the cheap sector, filter the most attractive ones and invest in all of them.

For example, I can see the following attractive ideas in IT Mid cap space

– Patni computers
– NIIT technology
– Zensar
– Hexaware
– Sonata
– Aztec

I have not done a detailed analysis on these companies yet and may discard a few. However I do feel that there is too much pessimism around these sectors. It not surprising that the market has beaten down these sectors as during bull runs, most investors prefer high growth companies and avoid companies which show low growth (even if they have a high Return on capital)

High PE v/s Low PE stocks – Most of you must have noticed that stocks with high PE or high valuations are getting hit harder when the market drops. This does not mean that these companies are over-valued or will do badly. If the analysis is correct and the companies does well, then investors in these companies should do well in the long term. However you have to be comfortable with the high volatility in the stock price. In comparison the low PE stocks, of which not much is expected, don’t drop as much during market drops. However they do not gain as much during the rise too.

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Kothari products demerger – an arbitrage opportunity ?

By Rohit Chauhan

In Arbitrage, Uncategorized

March 9, 2008

2 Min read

2 comments

Kothari products has announced the following de-merger plan

has approved the proposal for scheme of arrangement between the Company and Pan Pang India Ltd., for demerger of Pan Masala Division, Bevarages Division and Trading Division into Pan Parag India Ltd., subject to approval of the Stock Exchanges, its shareholders and the Hon’ble High Court and the necessary approvals under various statutes. Further the Company has informed that, the Board of Directors has also approved valuation report of M/s. Haresh Upendra & Co. Chartered Accountants, recommending exchange ratio of 1 Equity Share of Rs 10/- each of Pan Pang India Ltd for every 1 Equity Share of Rs 10/- each held by the shareholders in the Company. The Scheme of Arrangement provides for the exit to small Shareholders holding Equity Shares in Physical Form.

My earlier views on kothari products are here and here

Following is a comment from the 2007 Annual report – director’s report
In view of the risks associated with the Pan Masala Industry in the form of Governmental bans, the Company has decided to diversify into the business of Real Estate, constructions, builders etc. which is a booming business presently and which is growing at a very high speed. The market presents an attractive investment opportunity in the area by virtue of diversification. Your Company with requisite financial strength and proven managerial skills, stands in a position to seize the opportunity. To avoid any adverse impact on the growth of new business, management is considering various options for restructuring to seperate other businesses in a most efficient and transparent manner.

I am looking at kothari products as a short term arbitrage opportunity based on the following hypothesis – demerger would unlock the value in the company.

Kothari product would demerge the pan masala and other associated business from the parent company. The post de-merger company will be into real estate and construction business. The sum of value of kothari products (post merger) and pan parag ltd should be greater than Kothari products (pre-merger)

My question
1. Does the shareholders get 1 share of panparag and Kothari products (post de-merger) each based on 1 share of Kothari products (pre-demerger) ?
2. What happens to the Investments and cash on the books ?

Would appreciate any inputs on my questions ?
Please read disclaimer on the blog.

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ICICI bank news – some comments

By Rohit Chauhan

In Uncategorized, Views on news

March 6, 2008

2 Min read

9 comments

Deepak has posted on the current news around ICICI.

See – ICICI’s Disclosure See-Saws: Openly Making Fools Of Us

Following is my comment . You can read the discussion and all the comments on his blog

Deepak – Although it would be good to have more disclosure, it may be risky for a bank to do so also.

In addition the changes in the loss estimates seem to be consistent with what is happening in the market. For derivatives, accounting requires that the losses of mark to market are passed through the P&L even if the contracts are held to maturity (see this year’s berkshire hathaway AR for some discussion on this)

So as the markets are deteriorating, the mark to market losses could increase and the bank will have to recognize them. This is also consistent with the banks claims that these are held to maturity and may not have losses (similar to a goverment bond portfolio where you may have mark to losses, but if you hold the bonds to maturity there may be no losses).

I am not saying that is case with icici, but it may be possible. Also icici may be communicating only required information, but i really doubt they can fudge the data without a serious consequence.

Regarding the solvency, the bank has a networth of almost 12bn USD. Even if they lose 50% of their derivatives portfolio, you are looking at a drop in the CAR from 15% to somewhere around 13-14%. Not good for the stock, but definitely not a solvency issue. In addition the bank has a lot of assets on the books at book value like their insurance subs, icici direct etc. so they do have some hidden assets too.

disclosure – i am neither long nor short this stock

Additional points

The above discussion does not mean that I think ICICI is a good investment or otherwise. A 250 Mn USD loss is still less than 1% of the asset base of the bank. The bank has a 1.47% Net NPA on its books. I am not sure if a 1% increase in NPA would have created such a hysteria.
On the contrary the bigger risk for the bank is the retail portfolio and NPA’s which can develop in the future or other hidden liabilities on the balance sheet.

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NIIT Tech – Few additional points

Analysis – NIIT Tech

Prof Greenwald’s valueinvesting talk

Inflation, Rupee-dollar rate and impact on stocks

Mr Simpleton and Mr Hotshot Investor

Portfolio management and anchoring

Ouch !!

Clusters of Investment ideas

Kothari products demerger – an arbitrage opportunity ?

ICICI bank news – some comments

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